Can High Oil Prices Be Good?

World oil prices crossed $40 a barrel in mid-summer, and have since climbed to the mid-$50's. Today's oil prices are still only two-thirds the real peak reached during the Iranian Revolution of 1979, and future markets expect the oil price to fall back and settle at perhaps $45 a barrel. But the current high level of oil prices has led forecasters to start reining in their expectations for economic growth.

"Higher oil prices are here to stay," says the American economic forecaster Allen Sinai. "[T]hat has to subtract growth and could cause core inflation to pick up." Indeed, according to Sinai, higher oil prices are "the biggest risk...since the bursting of the stock-market bubble in 2000-2001."

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Sinai is hardly alone. If the oil price stays at $40 a barrel, expect it to have next to no effect on short-term world GDP growth. But if the oil price remains at or near $60 a barrel, expect everyone's forecasts of GDP growth to be reduced by 1% per year.

High oil prices also threaten to slow long-term productivity growth. With high - and volatile - oil prices, businesses will focus their investments less on boosting productivity and more on maintaining flexible energy usage. At $40 a barrel, expect oil prices to slow the long-run growth rate of the world's potential output by 0.1% per year. At $60 a barrel, expect the "measured" long-term rate of potential world output growth to slow by roughly 0.3% per year.

With most shocks to the world economy, we expect central banks to take steps to offset their effects. When business investment committees become more cautious, we expect to see the Federal Reserve, the European Central Bank, the Bank of England, and others lower interest rates to make the numbers more attractive. If consumers go on a spending binge, we expect the world's central banks to raise interest rates to cool off construction spending and free up the resources needed to prevent shortage-inducing inflation.

But this economic logic does not apply in the case of increases in oil prices. Although high oil prices look like a tax on business activity that depresses aggregate demand, they also raise inflation, both directly and indirectly.

Central banks respond to lowered demand by reducing interest rates and to higher expected inflation by raising interest rates. Because high oil prices both lower demand and raise inflation, central banks respond by doing little or nothing. The effects of high oil prices thus flow through to the economy without being moderated by the world's central banks leaning against the wind.

Yet if we take a very long-term view, it is not so clear that high oil prices are bad for the world as a whole. For example, if high oil prices were the result of taxes that were then redistributed to oil users, they would be unambiguously good.

To be sure, most taxes entail heavy "excess burdens": the cost is significantly greater than the value of the revenue raised because of potential taxpayers' myriad attempts at evasion and avoidance. A tax on oil, however, does not entail excess burdens. On the contrary, it implies excess benefits . Shifts to more energy-efficient means of transportation ease congestion. Attempts to shave costs by economizing on energy use reduce pollution. Higher prices for oil substitutes spur research into other energy technologies - research that is much needed today if we are to tackle the problems of global climate change tomorrow.

A well-designed tax on oil would also reduce demand, thereby lowering the potential for windfall profits for those who rule or own the ground over the oil deposits. A little more than a decade ago, Lloyd Bentsen, President Bill Clinton's first Treasury Secretary, tried to ensure precisely that, proposing to use a "BTU tax" to close America's fiscal deficit.

The Republican Party and the American Petroleum Institute sank that proposal. A decade later, we have high oil prices, but they are not due to a well-designed tax, either in America or elsewhere. As a result, the price boom is boosting windfall profits for the owners of oil deposits rather than improving countries' public finances.